Why the World Needs More Goldman Sachs

Critics have lined up against Goldman Sachs Group in the days since the U.S. Securities and Exchange Commission announced a fraud lawsuit against the Wall Street giant.

The SEC did little during the past 10 years to stop a technology bubble, Ponzi schemes and the buildup of the housing, stock market and banking crises. When federal regulators finally decided to act, they missed the mark.

Nevertheless, many see the allegations announced April 16 as an opportunity to knock Goldman down a notch from its perch atop the investment banking world. That would be a mistake which would hurt American competitiveness in the global arena.

Rather than regulate Goldman down to the average, a more rational approach would be to create an environment in the United States that rewards financial services innovation and helps other companies rise to Goldman’s level.

The world needs trailblazers at the top of the investment banking pyramid, and Goldman fills this role in a way that gives the United States an edge in global financial services. This edge creates jobs, boosts incomes and improves standards of living in the United States.

More competition at the top would generate even more of these benefits. Microsoft has Apple, Ford has General Motors and Coke has Pepsi. This competition pushes innovation and creates healthy checks and balances. But Goldman stands without peer in the aftermath of the global financial meltdown.

Bear Stearns and Lehman Brothers are gone, and Merrill Lynch has been absorbed by Bank of America. That leaves JP Morgan Chase and Morgan Stanley in the mix, but these banks generally operate today in separate categories from Goldman.

If the United States does not create a regulatory environment that encourages competition at Goldman’s level, other countries will step forward to fill this gap in a way that could shift the balance of power elsewhere.

Now is not the time for the United States to attack the reputation of its top investment bank — especially through allegations that seemingly lack merit. It should not be wrong to be a winner as long as you play by the rules.

The U.S. financial system is already weakened, and these allegations might only weaken it further, threatening a still fragile system that needs to start lending money to companies so they can hire people.

Circulating money
Reputation matters in banking. Even allegations never proved create problems for a publicly traded company like Goldman because so few people understand the complexities involved.

Goldman lives in a world of multibillion- and even trillion-dollar deals far removed from the commercial transactions that individual consumers see at their neighborhood banks.

Many who read about the SEC allegations in the media never studied finance or economics beyond an introductory course in high school. They don’t understand credit default swaps or collateralized debt obligations. But they do grasp concepts such as fraud, mismanagement and greed.

These words could stick long after Goldman clears itself in court.

People anxious to see Goldman punished for these perceived wrongs need to understand that what happens at the top of the investment banking world affects everything below — including how much people have to pay to borrow money and whether or not corporations get the funds they needs at reasonable costs so they can grow.

Goldman bankers do not deal in individual mortgages, car loans, credit card lines or small-business loans. But the institutional transactions they broker keep money flowing through the global financial system in a way that allows these things to occur.

Their job is to make financial markets function. They do not guarantee that an investor’s view of the market is the correct one.

They are part of a financial services system similar to the circulatory system in the human body. Instead of pumping blood, world banks pump about $25 trillion through the global financial body daily — a staggering figure that dwarfs the U.S. gross domestic product for an entire year.

Most people never see the circulation of this money. But they feel the effects quickly when arteries are blocked and the economy grinds to a halt.

Making markets
Understanding the SEC allegations against Goldman requires some understanding of the role investment banks play in keeping these arteries open.

In simple terms, an investment bank does not accept deposits like commercial banks. Instead, banks such as Goldman broker large-scale movement of funds between institutional buyers and sellers. Customers include other banks, large businesses and governments.

The transactions involve complex challenges that require customized and often innovative solutions. Ultimately, investment banks such as Goldman function as market makers for the specialized financial instruments they create to broker these deals.

Buyers and sellers could deal directly without investment banks in the middle, but this would be like farmers trying to sell food to consumers directly without the help of grocers in the middle. Problems and inefficiencies quickly arise that cause prices to climb.

Like grocers or any other market maker, investment bankers need buyers and sellers to survive. Their obligation is not to make buying decisions for investors, but to disclose relevant and accurate information so buyers can make their own decisions.

Grocers allow shoppers to squeeze the tomatoes or thump the melons before loading the produce into their carts. Likewise, investment bankers allow potential buyers to use independent advisers and other experts to assess the strength of the financial instruments before any deal is closed.

People who deal in these products must have a sophisticated understanding of financial services instruments and be able to analyze risk. In the end, buyers or sellers with doubts are free to walk away.

Managing the uncertainties inherent in this process comes with risk for the market maker in the middle. The key is maintaining balance between supply and demand.

In a grocery store setting, too much produce from farmers results in inventory being sold at a loss or spoiling on the shelf. Too little inventory results in shoppers paying too much or going home hungry.
The challenges are similar in investment banking. The first duty of a market maker such as Goldman is to be transparent, and then to manage risks for shareholders.

Nearly one month after the announcement of the SEC lawsuit, I have yet to see any data showing that Goldman manipulated the market or made excessive profits during the downturn.

Managing risk
What Goldman did instead was manage risk. Investment bankers who survive long term must recognize warning signs, such as market volatility or excess liquidity, and take appropriate precautions.
Bear Stearns did a bad job of managing risk in the months leading up to the global financial meltdown and ultimately collapsed and lost its shareholders’ investments. Goldman did a better job managing its risks and now faces a backlash for getting things right.

One allegation that has surfaced is that Goldman took a position against a product it brokered in a 2007 transaction. The buyer in this case bet that the housing market would continue to climb, but Goldman saw things differently and bought an insurance policy protecting itself against an impending collapse.

While some investors in the market expected housing prices to continue to rise, others like Goldman began to develop concern and take the opposite view. These investors turned to Goldman to implement their view.

Although people had their various opinions and analyses, no one really knew in 2007 how the market would behave. Housing prices had softened earlier but then recovered and continued to rise.

Regardless, some view Goldman’s behavior during this period as evidence of an apparent conflict of interest or lack of transparency. If the company saw a problem with subprime loans or housing prices in general, why move forward pushing a flawed product onto an unsuspecting buyer? What these critics need to understand, however, is that different viewpoints are what drive buyers and sellers to act in any market.

Some take a short position and bet prices will fall, while others take a long position and bet prices will rise. There are always two sides to the market, and Goldman must satisfy both sides or forfeit its role as a market maker.

Like grocers who must keep their shelves stocked with fresh produce, this requires Goldman to maintain an inventory of products for interested buyers. While these products sit on Goldman’s shelves waiting for buyers to emerge, purchasing an insurance policy against loss makes sense.
In the end, Goldman did not take a major position against the housing market. Instead, the company took a balanced position that allowed it to maintain an adequate inventory to satisfy both sides of the market.

This was the right thing to do.

Producing Innovation
More behavior like this would benefit the United States and support job creation and economic prosperity worldwide. The end result would be better risk management and more innovation across the industry.

Such innovation is crucial in the globalized economy, which has shifted from a labor-intensive model to a capital-intensive model as new technology improves efficiency and boosts output per worker.
The biggest cost in the production process today is not access to labor but access to financial services. This is especially true in advanced industrialized countries such as the United States.

The only way to keep these funding costs in check so that U.S.-based companies can compete on the world stage is through financial services innovation.

This differs from legislative innovation, which produced the subprime loans that pushed low-income families into homes they could not afford.

Financial services innovation comes when investment banks develop sophisticated instruments that satisfy the needs of buyers and sellers in a way that reduces risk and keeps money circulating through the system.

As the world’s premier investment banker, Goldman creates and delivers such instruments better than anyone else. Goldman understands the value of product creation, market making and risk management.

This is why the United States and the world need more companies like Goldman Sachs at the top, not fewer.

F. John Mathis, Ph.D., is a professor of global finance at Thunderbird School of Global Management in Glendale, Ariz., and director of Thunderbird’s Global Financial Services Center. The center is not affiliated with the Goldman Sachs 10,000 Women initiative, which includes Thunderbird partnerships in Afghanistan and Peru.

[This article has been reproduced with permission from Knowledge Network, the online thought leadership platform for Thunderbird School of Global Management https://thunderbird.asu.edu/knowledge-network/]